Central Banking and Government Policy: Canada, 1871

Theory and Fact

Free banking means a private enterprise competitive market in banking
services, including the provision of a medium of exchange (White, 1984,
1989; and Dowd, 1989). For the free banking proponent any govenment
intervention in banking would have to be justified by proof of some failure
in the market for banking services.

The Question

The Dominion note issue of 1871 was certainly a government
intervention in banking. Was it justified by a market failure
in the banking sector of the Canadian economy?

In Book II, Chapter 2 of the Wealth of Nations, Adam Smith approved
of a legal prohibition of small denomination paper currency issues by
private banks. He alleged a specfic market failure associated with the moral
hazard of over issue and failure to redeem. The moral hazard, he suggested
would arise from an invincible want of scruple with which the public would
accept such notes from any source. The ease of fraudulent issues would lead
to " ... the frequent bankruptcies to which such beggarly bankers
must be liable."

Smith was reporting contemporary practice, with
approval. About 1760, because of specific circumstances, the issue of small
denomination bank notes was permitted in England and Scotland. The result
was an excessive, inflationary issue that affected especially the working
classes who were paid in small denominations. In response to this market
failure, in 1765 in Scotland, and in 1775 in England, governments interfered
in the market by prohibiting the issue of notes below one pound
(Feavearyear, 162).

The question is, was the Canadian government's interference in the market,
with its issue of Dominion notes in 1871, a consequence of some similar market
failure in banking services in Canada? Was it an attempt to replace an
unsound small denomination currency with a sound government issue?

The Answer in the Debates in the House of Commons

On May 14, 1869, John Rose, the Minister of Finance, made it very clear that
the principal motive of the Government was to put the entire paper issue on
a sound and reliable footing. There was to be one national currency, issued
by the government through the banks, as in the United States, and for the
same reason as in that country: to prevent

the extreme
inconvience, not to say disaster, which resulted from [the] promiscous
circulation of the notes of Banks, established in various localities all
over the Union, each of which had a different degree of security to give
its note-holders (Rose, 10).

The Minister was building up to
the Uniform Currency Act of 1871, an Act that would provide a common currency
for the federation newly formed in 1867.

The Minister was also changing the nature of banking in Canada. The proposed
legislation would furnish the country with a currency backed by
government bonds, as were the "greenbacks" of the United States, and it would
put the Bank of Montreal in the position of a central bank. These other,
and perhaps more important matters affected the progress of the bill through
the House, but much of that story can be left out. All
that needs to be remembered is that the Government's motives were mixed,
to say the least, and that its stated purposes were not entirely candid.

The Minister's stated intention was reminiscent of the market failure agrument.
For reasons related to other aspects of the bill, the minister was forced to
resign (Masters, 1941; Shortt, 1920-34; Denison, 1966, vol. 2, 121-124). He
was replaced by Francis Hincks, who reintroduced the bill with a very
different intent with respect to all matters that went beyond simply
providing a uniform national currency. In passing, as if to get the matter
out of the way, the new Minister mentioned the need to provide security to
note holders (Debates, 1870, pp. 193-194). According to Hincks, however, the
previous minister had gone too far in trying to reduce the risk to note
holders (Debates, 1870, pp. 196-197). In fact, the market failure argument
was virtually retired by Hincks, who distinguished the principle intent of
his own bill to be to let the public "profit from the circulation of the
country". This, he said, the bill would do in two ways. It would require the
banks to hold one half of their cash reserves in Dominion notes, for which
they would have to pay the government in one way or another, and it would
take into the government's hands the issue of denominations below four
dollars (Debates, 1970, p. 198).

To this point in Hincks's remarks the Government's intent was not focused
on the market failure consideration, but focus on anything was lost when he
followed with a lenghty assurance of the security of Dominion notes, both
large and small denomination, and by a statement that

with
regard to the resolution on the currency, his object was simply to have one
uniform currency for the whole Dominion. (Debates, 1970, p. 200)

Having been interrupted by Mackenzie, Cartwright, and Bolton of the
Opposition, all of whom wanted "free banking", Hincks further clouded things
by asserting that

The best paper currency for the country would
be notes redeemable in gold ... for which the government would be
responsible (Debates, 1870, p. 234).

This he said was England's
system, supported for many years by the statements of Robert Peel, Lord
Sydenham, Mr. Jones-Lloyd, and David Ricardo; but, he said, without
explanation, that that system was impractical in Canada (Debates, 1870,
p. 233).

The Second and Third Readings of the bill clouded things even more. During
the Third reading, Etienne Cartier, who had been silent during the First
and Second readings, offered a summary of the Government's position
that included a statement that the Government would take over the issue of
smaller notes for the security of farmers who held them. The business
community, he said, generally held larger denomination notes, and was able
to take care of itself. In short, Cartier recalled the Smithian, market
failure argument from its retirement.

Debate in the House of Commons on the bill of 1871 seems not to have uncovered
the Government's "real" intentions. So, to get some further insight into the
possible motives of the Government, motives that were not stated, but were
impliict consquences of policies adopted in previous years, we must search
the previous years. It may be, for example, that on Smithian grounds the
Imperial Government had adopted a policy of prohibiting private
colonial banks from issuing small denomination bills, and that the reasons
given in 1870 were just convenient, contemporary rationalizations of a
practice stablished by Smithian Imperial decree in the earliest period of
Canadian banking.

The Answer Drawn from the Situation Prior to 1870

The first instruction from the Imperial Government concerning issues of
small denomination notes in Canada arrived in the early 1830s, when,
ostensibly, the Imperial authorities were attempting to facilitate trade by
introducing a common, sterling currency into all of the colonies. At the time,
Commissary General Routh wrote concerning the problem of dollar currency bank
notes in Canada.

It is expedient to restrict the bank notes on
renewal of [the banks's] several charters to sums of five pounds sterling
and to prevent their issue under that amount.

There had been an
earlier attempt on the part of the Imperial authorities to regulate the issue
of small denomination notes. Their stated motivation then was to meet the
need for a regular, secure currency, along the lines suggest by Adam Smith in
his rationalization of the issues of the Amsterdam bank (Smith, 446-455), and
along the lines of those who initially proposed the chartering of banks in
Canada (Neufeld, p. 38). Adam Shortt points out, however, that as a result
of historical accident the Imperial Government was profiting from the issue
of over-valued sterling silver, and wanted to increase its profit by extending
the issue throughout the Empire (Shortt, 1986, pp. 220-221). Quite possibly,
then, neither the alleged nor the "real" reasons for Imperial regulation of
small denomination paper currency involved the market failure argument of
Smith's Book II, Chapter 2.

Routh's suggestion was not taken in Canada, but a "hurried Act" of the
Legislative Assembly

... excluded from circulation in Lower
Canada any bank notes, or other notes, under five dollars, except those of
the incorporated banks of the province (Shortt, 1986, pp. 237, 239).

The motivation for giving the Lower Canada banks a monopoly of the
issue of small denomination notes was not mentioned in the Act.

There were some colonial interests opposed to small denomination issues by the
banks, but here again, the market-failure argument was not clearly involved.
Having had the paper issues of the pre-Conquest period repudiated by both
France and Britain, the French population was loath to get caught again.
Their concern looks like the market failure argument. At the same time,
however, the balance of payments was such that good currency tended to be
bought up by the banks, particularly the Bank of Montreal, for profitable
resale in the New York exchange market. So, in the early 1830s, there were
complaints from Lower Candian merchants that small denomination paper
currency was driving specie out of the country (Shortt, 1986, 26-268).

It seems, then that there were a number of reasons for a number of interests
to want to regulate the issue of small denomination currency. When the
Upper Canada Assembly considered applications for bank charters in 1834,
for example, the established Upper Canada banks petitioned to have the bills
of foreign [Lower Canada and United States] banks declared legal tender
only for values of 20 shillings and higher. Their hope was to establish a
monopoly over that part of the paper issue usually not returned for
redemption (Shortt, 1986, 304).

Adam Shortt's Answer to the Question of Motivation

In 1839, following the financial and political crisis of 1837, even before
the new Governor, Lord Sydenham, lectured the Assembly on the virtues of
the Currency School position, the Upper Canada Assembly considered the
possibility of a provincial government currency. The discussion at that
time was a repeat of a similar discussion that had taken place in 1821.
Adam Shortt cited the relevant 1821 Resolution at length.

Resolved, that it is the opinion of this House, that the establishment
of a provincial bank under proper restrictions would be beneficial to
the country, by remedying the great want of specie, by securing to ourselves
whatever advantages are to be derived from the issue of a paper currency,
and by establishing a circulating medium of known security, instead of
the paper of private banks, uncontrolled by charter or legislative
provisions, and which from it being rejected by the public receivers, does
not answer effectually all the purposes of trade (Shortt, 1986, 100).

In 1821, as in 1871, there were two main motivations alleged for a
government issued currency: a secure currency, which the private banks were
not providing, and fiscal benefits. Shortt thought the second of these, the
needs of the Provincial Treasury, to have been the most motivating of the two
in the subsequent fifty year progress towards the 1871 small denomination
government issue.

At every stage in the development the
pressing need of the government for something like a forced loan from the
people was the occasion of each new extension of the system (Shortt,
1986, 608).

In explanation of the 1871 emphasis on monopoly of the small denomination
issues, Shortt referred to Hincks himself.

... [with respect to]
the issue of all small notes below four dollars ... He referred to the fact,
so obvious at the time, that since the American Civil War the smaller note
issue of the banks had been supplanted by American silver. The Government
was already taking measures to rid the country of this silver in order to
make room for the circulation of the small Dominion notes. Thus by the
proposed changes the banks would suffer very little restriction while the
Government would considerably benefit (Shortt, 1986, 608). Because, of
course, the notes would not be returned for redemption, and the banks would
have to purchase government bonds to receive them.

From reading Shortt, it would seem that the extension of the issue of small
denomination Dominion notes in 1871 was an attempt to force a loan from the
people by issuing that portion of the currency that would least likely be
returned for redemption, and would least arouse the banks to political
opposition. It was not an Act that contradicted Adam Smith, so the
market failure argument could be used to support it in debate even though
the main motivation was fiscal benefit for the government.

Still, if allowance is made for the possibilty that Shortt's account of
the earlier period was as biased as his account of the Act of 1871, the
question of the Government's motivation in 1871 is thereby only dubiously
resolved. It has to be remembered that Shortt wrote his account in the first
two decades of the twentieth century, when he was busy trying to convince
the Senate Banking Committee that departure from the gold standard would
be disastrous. To correct for Shortt's possible bias some reference to
regulations relating to small denomination paper issues in nineteenth
century Britain would seem to be in order.

The Answer in Britain

In the late 1790s, during the war with France, Acts were passed allowing
both the Bank of England and the country banks to issue small denomination
notes.

The public accepted the notes because there was nothing
else and because they served the purposes of trade for the time being as
well as gold (Feavearyear, 171).

These acts remained in force until the time of the Bullion Committee
Report of 1810, at which time it seemed evident that

... the
note issue of the Bank of England had risen since 1797, particularly notes
of less than five pounds (Feavearyear, 183)

The conclusion was

... that the rise in the price of bullion
and the adverse exchanges was caused solely by an over-issue of Bank
of England notes (Feavearyear, 184).

It would seem, then, that the problem with small denomination issues by
private banks was as much that of inflation as of insecurity for
individual note holders. The small denominations were not prohibited at
the time of reestablished convertibility in 1821, and Feavearyear reports
the general opinion at the time of the 1825 crisis that

It was
the hundreds of small independent note issues, all capable of easy
expansion and all liable to rapid discredit, which were to blame
(Feavearyear, 223).

In 1826 an Act prohibited the issue of notes less than five pounds in
England and Wales. The Act was not extended to Scotland because there was
not the multipicity of small banks, with the result that there had never
been a failure to redeem, according to Feavearyear (Feavearyear, 226),
but that seems to reintroduce the market failure consideration.

Motivation in England and the View of Francis Hincks

The great issues of the middle and late years of the nineteenth century in
England were embodied in the Bank Charter Act of 1844. Although the
institutional structure of the banking system was a subject of the Act, its
principal focus was on macroeconomic control over prices and the general
level of economic activity, not on microeconomic efficiency as affected by
market failure. So, (1) because the Currency School doctrines on which that
Act was based were imported into Canada in the person of Lord Sydenham,
(2) because Hincks repeatedly stated that Sydenham's Currency School opinions,
though impractical, embodied what was best for Canada, and (3) because Hincks
was the author of the Act of 1871, it would seem either (1) that the focus of
the Act of 1871 was macroeconomic control, and not microeconomic efficiency,
or (2) the aspect of Sydenham's scheme that was, in Hinck's view, impractical
in Canada was its focus on macroeconomic control. So, in this view of things,
the question boils down to what was the aspect of Sydenham's Currency School
proposal that Hincks found impractical in Canada?

Adam Shortt on What Was Impractical

What was proposed as Currency School doctrine in
Canada in the early 1840s was not a carbon copy of the English Currency
School prooposal, but a government owned bank with a monopoly of the issue
of currency. This proposal had been made in the Canadas in 1821. It was
thoroughly discussed in both Upper and Lower Canadian Assemblies in 1820
and 1821. It was, in fact, embodied in an Act of the Upper Canadian
Assembly but failed to be proclaimed only by seeming accident. The
Currency School proposal in Canada played the role in 1840 that
the Social Credit proposal of Major Douglas in Canada in 1920 (Neill).
Neither had effects beyond changing the semantics of ongoing debate.
Further, it is significant that the failed 1821 Upper Canada Act could not
have established an inconvertible currency even if enacted, because an
inconvertible currency would have violated the British statute 4 Geo. III
chap. 34. Further yet, as Shortt was quick to point out, it would have been
open to abuse by the government (Shortt 1986, 79-80, 99-101), just as the
issues of the New England colonies and of Virginia, against which 4 GEo. III,
chap. 34 was directed, were open to abuse and in fact were abused.

Sydenham's Currency School paradigm was rejected in Canada, according to
Adam Shortt, because conditions in a frontier country with a few primary
product exports were quite other than those of a fully developed and
balanced economy, such as that of England. What the frontier wanted was
not stability and a safe place to put excess capital, that is, in general,
macroeconomic stability. What the frontier wanted was expansion and more
capital to put in places of expected high return, that is, in general,
growth and development. The need was for capital, so the
currency was organized, foolishly according to Shortt, to generate
capital (Shortt, 1986, 406-409). But here we have Shortt again making the two
basic points of all of his writings: first, that the Canadian banks were
typically North American, and well within the traditions of early United
States banking (Shortt, 1896, 1-17); and that the primary thrust of Canadian
banking legislation up to and including the Act of 1871, was to generate
capital for public works yet to be undertaken, or undertaken and not yet
paid for.

The American Way in Canada

Shortt was surely right in his assessment of American Banking. It had been
the "habit" of the original English colonies to issue paper in lieu of taxes,
and the Continental Congress also issued paper. During the Civil War the U.S.
Federal government issued the so-called Greenbacks. In the latter instance no
denomination less than $5.00 was to be isssued, but specie disappeared
from circulation and fractional paper currency was then issued. When a new
system of national banks was put in place in 1863, $300,000,000.00 was issued
on the Security of United States bonds, one sixth of which was in
denominations of less that $5.00. None of it was convertible, and there was
strong agitation for the permanent acceptance of an inconvertible national
curency (Hepburn, 1903, 185, 191, 307-08). In the United States, as in
Canada, the problem of small denomination paper, that is, the moral hazard
of inconvertability and over issue, was recongnized, but circumstances were
such that it was given a low priority in policy.

Nice questions could be raised concerning the issue of currency to pay for
services directly, and the issue of currency on security of government bonds,
the first of which may be said to be an issue for revenue, and the second an
issue for capital. And there are questions to be answered about the extent
to which currencies issued by the colonies were to cover war debts as
opposed to debts associated with economic development. Indeed, questions could
be raised about the extent to which American practices were
different from European practicies in these matters; but there is a limit
to what should be attempted in the fine tuning of arguments - a limit that
has already been passed here. Banking was not the same thing in America
and Europe, not only because America was a frontier economy being built in
a rush from the top down (Innis, 28, 201), but at the top in Europe there was
innovation that found a ready testing ground in America. In the early years
in America paper money was disassociated from specie and precious metals,
and "Bank ... in colonial language meant an issue of paper money"
(Schumpeter, 293-299, Weeder, 314-330, 318).

Conclusion

Shortt's answer concerning the "why" of the 1871 issue was well founded,
though his judgement on the policy correctness of the "why" may not have
been. The small denomination issue of 1871 was not intended to remedy the
microeconomic market failure pointed out by Adam Smith. it was not intended
to remedy macroeconomic instability. Rather, it was intended to produce
capital to finance public works.

Proponents of free banking have nothing to explain away with
respect to the market failure motivation of the Dominion Government at the
time of the small denomination issue of 1871. Market failure in banking
was not the problem motivating the legislation. Still, insofar as they were
represented by the Opposition in Parliament, they were very disapproving
of the actual motivation. The chief motivation of the Government was
consistent with the propensity-to-abuse assertions of free banking
proponents. If Rose's original bill had passed, Canada would have had a
central bank intended to facilitate the revenne grab that Vera Smith, an
historian of the free banking pursuasion, has suggested was typical of the
establishment of all central banks (Smith, 1936).

Rose's bill was not passed, and Canada did not get a central bank until
1935. All it got was an issue of Dominion notes; and, of course, the
motivation of the Canadian Government in establishing the Bank of Canada in
1935 cannot be deduced from what was intended in 1871.

References and Bibliograpy

Canada, Debates of the House of Commons

Denison, M., Canada's First Bank, Macmillan, Toronto, 1966

Dowd, K., The State and the Monetary System, Philip Allen, New York, 1989.

Feavearyear, A.E., The Pound Sterling: A History of English Money,
.....Oxford University Press, London, 1931.